There are two ways you can make money as a shareholder.
The first way is through capital growth. This occurs if the value of the shares you own increases between the time you buy and sell them.
Another way to gain comes as some companies use the profit they generate to pay dividends to shareholders as a reward for their investment.
When you combine the two, capital growth and dividends, you get total shareholder return.
Total shareholder return equals the profit or loss from net share price change, plus any dividends received over a given period.
Shareholder return is calculated pre-tax and assumes that all dividends are reinvested.
When you reinvest your dividends, it means you use all or part of the dollar value of your dividends to buy new shares of the company. This enables you to increase your shareholding in the company.
What does total shareholder return tell you?
Some stocks may see larger capital growth but pay lower or no dividends, while others may have a lesser increase in share prices but offer higher dividends.
By looking at a company’s total shareholder return, instead of merely its share price changes, you can work out how well an investment has performed over time.
On the Australian Securities Exchange, ‘price indices’ measure only the increase or decrease in prices. To calculate both the price changes and dividend income, you’ll have to look for the ‘total return indices’ or ‘accumulation indices’.
For example, the benchmark S&P/ASX 200 Index measures only the price changes, while the S&P/ASX 200 Total Return Index calculates both price growth and dividend income, assuming that all dividends are reinvested.
While it can be useful to compare the total shareholder returns of two different companies, keep in mind that past performance is not indicative of future performance. A company that performs well over one year may not repeat that the next year.
What else to consider?
Shareholder return is not the only thing you have to consider when choosing which shares to buy. It’s vital to use a number of valuation methods to assess the quality and value of a company.
That’s because share price growth, for example, can be driven by many different reasons including market sentiment and investor expectation. The share price does not necessarily represent the true value of a company and its earnings potential.
With this in mind, you should also consider looking at a company’s price to earnings ratio, which will tell you how its share price relates to its ability to generate earnings. The ratio allows you to compare a stock’s earnings potential against its peers in the same sector or to that of the broader market.
Other useful measures to look at include earnings per share and dividend yield.
It’s also important to examine a company’s position in its market, its management team, and its ability to grow in the future.